Today Environmental, Social, and Governance (ESG) factors have become key drivers of value, proving that financial performance is no longer measured only in terms of market size and profit. Investors have begun to understand that sustainability is just as important as finance when evaluating a firm’s performance. And this increasing interest from investors has resulted in organizations and corporates paying more attention to ESG factors. Organizations today are focusing more and more on building efficient ESG strategies and frameworks. In this article, we are going to provide you with a brief introduction to various ESG frameworks and investment strategies used by investors.
What are ESG frameworks?
ESG frameworks are systems for standardizing the reporting and disclosure of ESG metrics. They act as general guidelines for corporates/ industries guiding them on how to report their ESG performances. These frameworks are mostly developed by non-profit organizations, NGOs, business groups, and others. As a result, they vary widely in areas of focus. There is no set regulation yet regarding which framework to use, so it’s up to the organization to select the framework to use. Today there are various frameworks available to select from. Below is the list of a few most used frameworks:
- The Global Reporting Initiative (GRI)
- Sustainability Accounting Standards Board (SASB)
- International Integrated Reporting Council (IIRC)
- The Workforce Disclosure Initiative (WDI)
- Task Force on Climate-related Financial Disclosures (TCFD)
- Climate Disclosure Standards Board (CDSB)
- Science-Based Targets initiative (SBTi)
- UN Principles for Responsible Investment (PRI)
- World Economic Forum (WEF) Stakeholder Capitalism Metrics
- Boardclic’s ESG Index
- Morgan Stanley Capital International (MSCI)
How to pick an ESG framework?
As we can see there are multiple frameworks available to select from today, so the obvious question that comes to mind is how to pick one, what things need to be looked at while selecting a particular ESG framework for an organization?
- Know your organization. Keep your sector and industry top of mind when deciding which framework is most appropriate to implement. This is especially true for some of the frameworks listed above such as the SASB and its set of 77 industry-specific standards.
- Know whom you are reporting to. Think about what drives your reporting needs. Are you going for multiple disclosures across Economic, Environment, and Social categories? Which sustainability goals are more important? Or do you need a complete framework that covers all financial and non-financial issues? The answer to this may depend on what your shareholders, lenders, community partners, and other stakeholders would like to see.
- Geography matters. Disclosure requirements vary by country and region. From the EU’s Corporate Sustainability Reporting Directive (CSRD) to the UK’s constantly changing disclosure requirements, having a framework that fits the required reporting standards is essential.
Investment strategies used by investors:
Based on how an investor views ESG, what kind of data they look after, and their strategies, ESG investment can be classified into two types: 1) Passive ESG investing 2) Active ESG investing.
Passive ESG investing:
Passive ESG investors are those investors who do give importance to ESG factors while investing, but they don’t put any weight on the ESG performance of an organization. Under passive investing, an investor tends to screen the company on the basis of minimum ESG criteria and restrain from investing in companies that don’t meet those criteria, but they don’t put any real score to ESG. Some of the commonly used passive investing strategies are:
- Exclusion policy: Under the exclusion policy investors exclude specific investment sectors that they find are in conflict with their ESG criteria. Then, a standard investment approach is applied to non-excluded sectors. For example, a particular financial institute focusing on net zero may ban investing in any fossil fuel-based power company.
- Norms-based exclusion: it is a variation of the exclusion policy. This screening policy is more comprehensive as it excludes investments in companies that do not follow widely accepted norms outlined by international standards such as the UN Global Compact, the OECD guidelines for multinational enterprises, or the ILO core conventions.
Active ESG investing:
Active ESG investor tends to be more involved in the organization’s ESG performance. Active ESG investing strategies put real weight on ESG, which further motivates the organization to perform better on their ESG factors. Few of the most common use active ESG strategies are:
- Active ownership: Active ownership strategy is designed to motivate companies to integrate ESG strategies. While investors can screen their new investments, for many large institutional advisors, divesting from their previous investments because of non-ESG compliance is not easy. In such a situation active ownership strategies act as a way to influence the company that they invested in to focus on ESG. There are varying levels of engagement; investors can monitor the ESG performance of companies or influence the company through regular meetings with management.
- ESG integration: ESG integration means incorporating ESG data, alongside traditional financial analysis, into the investment selection process. In this situation, the company put a weightage on ESG analysis just like the financial analysis. The primary objective is to achieve higher returns. Unlike the best-in-class method, ESG integration does not require benchmarking based on the peer group.
- Best-in-class: Just like the name suggests, under the best-in-class strategy, investors prioritize investing in companies that are either at the top of the entire ESG universe or at the top of their respective sectors in meeting ESG criteria. Under this strategy, investors look at various benchmarking indexes to evaluate the companies’ standing in the respective ESG field. The goal best-in-class approach is to encourage companies to be competitive in the field of ESG as well
The thing with ESG is that it is a vast topic; unlike financial aspects of performance (which have standardized parameters) ESG factors are diverse, unique, and most importantly unstandardized. This has resulted in chaos when it comes to forming ESG strategies and frameworks. Today, the biggest challenge to ESG is this lack of standards. Many companies even struggle to properly define the aspects of ESG let alone form strategies. To ease this situation a bit, many ESG frameworks have been established by various organizations but even then, since there is no proper regulation, companies still find themselves confused regarding which framework to use.